The $1.5 Trillion Business Tax Change Flying Under the Radar

By Richard Rubin 

Republicans looking to rewrite the U.S. tax code are taking aim at one of the foundations of modern finance — the deduction that companies get for interest they pay on debt.

That deduction affects everyone from titans of Wall Street who load up on junk bonds to pay for multibillion-dollar corporate takeovers to wheat farmers in the Midwest looking to make ends meet before harvest. Yet a House Republican proposal to eliminate the deduction has gotten relatively little sustained public attention or lobbying pressure.

Thanks in part to the deduction, the U.S. financial system is heavily oriented toward debt, which is cheaper than equity financing and widely accessible. In 2015, U.S. businesses paid in all $1.3 trillion in gross interest, according to Commerce Department data, equal in magnitude to the total economic output of Australia.

Getting rid of the deduction for net interest expense, as House Republicans propose, would alter finance. It also would generate about $1.5 trillion in revenue for the government over a decade, according to the Tax Foundation, allowing for investment breaks and rate cuts elsewhere in the tax code.

The dollars at stake are even more than another controversial proposal being pushed by House Republicans known as border adjustment, which would tax imports and exempt exports. The border adjustment plan has been under attack from retailers and Republican senators, whose resistance has put it on the brink of failure. But the idea of eliminating or limiting the interest deduction has generated less vocal opposition, giving it a real chance of passage, perhaps in a scaled-back form.

“The overall goal is to be pro-growth. What we’re proposing is to take the tax preference from the source of funds, borrowing, and take that preference to the use of funds, business investment and buildings, equipment, software, technology,” Rep. Kevin Brady (R., Texas), the author of the plan, said at The Wall Street Journal CFO network this month.

In a world with no interest deduction, debt-fueled leveraged buyouts by private-equity titans could become more expensive to finance and junk bonds less appealing. “That’s not necessarily bad for society,” said David Beim, a retired finance professor at Columbia University. “We have too much systemic financial risk in our economy.”

But for some debt-reliant businesses the interest deduction’s demise could be a significant blow. Crop growers who depend on bridge loans to work through seasonal business fluctuations could face higher tax bills for little benefit.

Andy Hill, who farms corn and soybeans on about 600 acres in north-central Iowa, said he pays less than $10,000 a year in interest on a line of credit between $100,000 and $200,000. That loan helps him bridge gaps between his expenses and his income, between when he needs to buy seed and fertilizer and when he sells his crops.

“[Losing the ability to deduct interest] wouldn’t put me in the red by any stretch of the imagination, but it makes it very debilitating as far as household income,” said Mr. Hill, who added that he has spoken to both of his senators and his House member about the issue.

Midsize businesses may also get squeezed.

“The people that utilize debt, they utilize it because they don’t have the cash and they don’t have the access to equity,” said Robert Moskovitz, chief financial officer of Leaf Commercial Capital, which finances businesses’ purchases of items like copiers and telephone systems. “A dry cleaner in Des Moines, Iowa? Where is he going to get equity? He can’t do an IPO.”

The idea behind the Republican plan is to pair the elimination of this deduction together with immediate deductions for investments in equipment and other long-lived assets. Party leaders expect the capital write-offs would encourage more investment and growth and greater worker productivity, but not the debt often associated with it.

From an accounting standpoint, the tradeoff could hurt companies’ reported earnings because immediate expensing would just shift the timing of deductions and the loss of the interest deduction would be a permanent change.

Dennis Kelleher, chief financial officer of CF Industries Holdings Inc., a fertilizer manufacturer, said at a conference in May that the most important thing for the company would be a lower corporate tax rate.

“I don’t think that’s a good thing,” he said of repealing the interest deduction. “I suspect that won’t happen because it would be rather destabilizing, just to the capital markets generally.”

Unlike border adjustment, the idea of accelerating investment write-offs has broad support from conservative groups, such as the National Taxpayers Union, and some support from Democrats, including Jason Furman, who was President Barack Obama’s chief economist. It was a move in the opposite direction, toward longer depreciation schedules, that helped doom a Republican tax plan in 2014.

The tax code treats equity financing more harshly than debt. While interest is deductible, dividend payments typically aren’t. Corporate profits can thus be subject to two layers of tax — once at the business level and then when it goes to shareholders in the form of a dividend.

That means the effective marginal tax rate on equity-financed corporate investments is 34.5%, according to a report released by the Treasury Department this year in the waning days of the Obama administration. The corresponding rate for debt-financed investment is negative 5%. That subsidy for corporate debt “potentially creates a large tax-induced distortion in business decision making,” the report says.

But borrowing and deducting interest are deeply ingrained in American corporate finance as a normal cost of doing business. Dislodging the traditional practice will be challenging. Some firms might look to borrow offshore instead to reap tax benefits elsewhere.

“I don’t even think people think about it much,” said Robert Pozen, a senior lecturer at MIT’s Sloan School of Management. “It’s clear that they’re going to finance it by debt if they have a big acquisition or a big project.”

Because so much is at stake for so many sectors, writing the law could get messy. Mr. Brady said small businesses and utilities could get exceptions or specialized rules, as would debt-financed purchases of land, which wouldn’t be eligible for immediate investment write-offs.

The administration, including a president who proclaimed himself the “king of debt,” has been wary of repealing the interest deduction but hasn’t drawn a hard line. Treasury secretary Steven Mnuchin has said his preference is to keep it. Resistance could build among Republicans in Congress and among real-estate firms and the agriculture industry, which have formed a coalition to fight the proposal. Yet financial markets so far have registered little reaction to the prospect of the interest deduction going away. One reason: The tax change most likely would apply to new loans only.

Junk-rated bonds, issued by companies that typically carry a large amount of debt, have returned 4.6% this year — better than the 4.3% returns of investment-grade bonds, according to Bloomberg Barclays data.

Without repealing the interest deduction, Republicans’ hopes of providing full and immediate deductions for capital investment are dim. They probably wouldn’t have enough money to offset the upfront fiscal cost of accelerating all those deductions.

The plus for the GOP is that this issue is more familiar and less black-and-white than the complex border adjustment plan. Limits on interest and accelerated write-offs could be dialed to a politically comfortable spot. If Republicans can’t stomach full repeal of the interest deduction and immediate write-offs, they could try something short of that with, say, half of capital expenses being deductible and half of interest being deductible.

Andrea , head of global private investment research at Cambridge Associates, which advises institutions that invest in private equity, said the industry would survive a tax overhaul that removes the interest deduction.

“The effects will reverberate for sure,” especially among larger firms that rely more on debt, she said. “But debt is still going to be cheaper than equity, so I don’t think it’s going away.”

–Sam Goldfarb contributed to this article.